While China has done relatively well to weather the strong negative trends of the global economic recession, it has certainly not been left unscathed.
One consequence which has emerged is a significant increase in the number of foreign invested enterprises pressed with the urgency to liquidate their assets, whether voluntarily or through the bankruptcy system. Under such circumstances, a company must first assess the value of all remaining assets in the company. Based on the value of these assets, the company is able to then determine whether they are valued at a sufficient level to warrant a voluntary liquidation through the establishment of a liquidation committee, or whether it would be best to file for bankruptcy and leave the burden to the court and bankruptcy administrator. A third alternative would be to illegally withdraw from China, which however can be risk if the investor ever wants to work in China again.
The most common and preferred method for liquidation by foreign enterprises in China is to voluntarily terminate its operations and then de-register the company with the proper authorities. Voluntary liquidation may be paramount in circumstances where substantial value still exists in the remaining assets, and the shareholders see an advantage to maintaining control over the liquidation process. Additionally, avoiding the stigma of bankruptcy may be beneficial if the shareholders desire to continue professional relationships with vendors, suppliers, customers, and employees.
The decision to terminate operations is made by the shareholders and/or board of directors, who then appoint a liquidation committee to handle the procedures related to the dissolution. While shareholders attempt to appoint members to this committee who will represent their interests, the members do have fiduciary duties to act in the best interest of the company and its creditors, with penalties for violation of this duty or any laws, administrative regulations, or the company’s Articles of Association. Once the committee has been established, it is imperative to immediately take control of the company stamps, licenses, and bank accounts to prevent any further business activity. With control of the company, the committee can then turn to the process of dissolution, including arranging for government approvals, terminating employee contracts, collecting or writing off debts, selling off remaining assets, reimbursing creditors, filing liquidation and audit reports, and de-registration procedures.
Obtaining final approval for de-registration from the relevant government departments, and in particular the tax authorities, is often the most challenging part of the liquidation process. These departments have the authority to require any outstanding issue(s) to be resolved before endorsing the final de-registration. It is at this stage that the liquidation committee is often caught by surprise with claims and issues related to unpaid taxes, social insurance, foreign exchange, customs duties, and the like.
To prevent any incidents which may cause delay to de-registration, a foreign invested company may wish to adopt a few precautionary business practices. First, companies are advised to retain and organize all relevant documentation, especially financial documents, to ensure ease of accessibility in the event they are required for verification by tax and other authorities. In furtherance of this practice, a company may consider reconciling and organizing its financial books; cataloging all tax payment evidence for later use in receiving the tax clearance certificate; and assembling VAT and other invoices together for liquidation sales. Second, it is advantageous for the individual working on behalf of the enterprise to have a good relationship with the authorities, as this will increase the likelihood of a smooth procedure.
Bankruptcy and the Enterprise Bankruptcy Law
At times the financial pressure of a voluntary liquidation becomes too great; other times the value of assets are initially insufficient to expend the time and resources necessary to hire professionals to support the liquidation committee. In such situations, the most viable solution may be to file a petition for bankruptcy, placing the complications of liquidation in the hands of the court and bankruptcy administrator.
Under the Law of People’s Republic of China on Enterprise Bankruptcy Law (“EBL”) promulgated in 2006, bankruptcy cases are initiated by an application filed with the People's Court where the debtor company is domiciled. Both the debtor company and its creditors have the right to file an application for bankruptcy, conditioned upon certain requirements. For the debtor, a petition may be filed if it is: (a) cash-flow insolvent; (b) balance-sheet insolvent; or (c) “obviously incapable of clearing off all its debts.” This most likely refers to the immanency of insolvency evidenced by the corporate balance sheets. Conversely, a creditor may only file an application if the debtor is cash-flow insolvent. Pursuant to the EBL, a debtor company may be declared bankrupt, may apply for reorganization, or may apply for conciliation. Reorganization and conciliation will not be discussed in this article. However, it should be noted that these options are not commonly chosen, as the concepts are still relatively new to China and most individuals do not yet understand the full procedures. If a debtor company is declared bankrupt, the sale of its assets must be conducted by auction, unless the creditor's meeting decides otherwise.
Upon receiving an application, the court then has fifteen days to determine whether to accept the petition. If the application is accepted, the court will appoint a bankruptcy administrator, a position commonly held by law firms, accounting firms, or bankruptcy liquidation firms. The administrator has broad powers to take over the debtor company during bankruptcy proceedings, including the managing of assets, operations, and legal proceedings of the debtor. However, the bankruptcy administrator must report to the court and the creditor's meeting. Also following the acceptance of an application, the court will set a time period during which creditors may declare their rights and claims, usually between 30 and 90 days. Creditors may submit a statement to the bankruptcy administrator declaring its claim, any pledges to that claim, and evidence of the claim. The bankruptcy administrator then notifies all known creditors of the time and location of an official creditors' meeting.
The creditors’ meeting has the authority, among others, to oversee management and liquidation of the estate and approve plans regarding the realization and distribution of the debtor’s assets. The creditors’ meeting may also appoint a creditors’ committee, which consists of creditor representatives selected at the creditors’ meeting as well as an employee representative or a representative of the work union of the relevant debtor. In practice, the committee adopts a supervisory role, leaving the development of a liquidation plan to the bankruptcy administrator. The administrator then submits the report to the creditors’ committee, who will accept the plan insofar as it is regarded
as fair to all the parties.
Secured creditors have payment priority out of the proceeds of their collateral, with any shortfall classified as unsecured debt. Following these creditors, the distribution priority is as follows:
- Bankruptcy expenses and community liabilities;
- Unpaid employees’ salaries, severance pay, medical insurance, and pension premiums;
- Unpaid social insurance premiums (other than those listed above) and taxes; and
- Other unsecured creditors (including shareholders’ claims). The EBL brings China's bankruptcy system closer to international standards and, while challenges still remain, improves the transparency and certainty of the China’s bankruptcy system.
Illegal Withdrawal of an Enterprise
No doubt compliance with the rules and regulations regarding liquidations, whether voluntarily or through bankruptcy, accrues supplementary costs for the enterprise, both financially and otherwise. Consequently, China has recently witnessed an increase in the trend of foreign enterprises, especially smaller companies, to abandon their operations without observing the statutory liquidation process, thereby leaving behind outstanding bank loans, unpaid debts to creditors and employees, and unpaid taxes. While the financial incentive and ease of exit may be tempting, there are significant potential consequences to consider. First, any favorable reputation that has been established by the company and shareholder will be quickly and permanently extinguished. Second, the shareholders, actual controllers, legal representative, and other members of the board of directors may be held jointly responsible for the abandoned company’s debts and its failure to meet its legal obligations, notwithstanding the limited liability character of the company. Third, the Chinese government has issued a circular declaring the government’s right to prosecute foreign offenders through a cross border pursuit. And fourth, an illegal withdrawal may also result in company members being black listed by the local authorities, which can have the affect of preventing investment in China at any time in the future.
A business presence in China can be very profitable and have tremendous advantages for a foreign enterprise. However, as in any country, it is important to know the full extent of the law, and how the law regulates your business activities and organizational development. China is currently experiencing a substantial transformation within its legal system, and the government is continuously attempting to create a more harmonized business climate for foreign and domestic companies alike. It is therefore essential to remain updated with regard to legal developments and be aware of the financial standing of your company to ensure preparedness in the event an exit strategy becomes necessary.